No . 2004 / 27 Capital Flows , Exchange Rate Regime , and Macroeconomic Performance in Mexico

This paper analyzes the short-term effects of foreign capital flows on aggregate demand in Mexico: their magnitude, transmission channels, and the possible influence of the country’s choice of exchange rate regime. The study is motivated by the introduction of a floating system in December 1994, in a context of renewed volatility of international capital flows. During the band period, in the early 1990s, capital flows different from FDI had a strong effect on both consumption and investment demand. The real exchange rate and stock market prices were important transmission channels. After the adoption of the floating system, the link with consumption has persisted; the effect of capital flows on domestic investment, in contrast, has tended to disappear. The findings of the paper are consistent with the idea that the insulation of investment from the vagaries of capital flows is partly explained by an observed reduction in the correlation of the real exchange rate and the stock market price index with capital flows.